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Understanding one’s life insurance policy is good, but understanding the tax rules associated with it is even better.

The life insurance industry has developed in complexity and diversity over the years. When life insurance policies were originally created, they were insurance vehicles but, over time, have also become investment vehicles.

Nowadays, these two types of policies are difficult to separate one from the other. Both have a mix of complex rules, regulations and expectations, which are off-putting to policyholders and potential clients.

In order to make sense of this, the following information provides some helpful tips to simplify this confusing topic.

Note: This information is based on certain life insurance policy, tax, and legal assumptions, but it not meant as legal or tax advice and is, also, subject to change. Only your attorney, accountant, or other tax professional can give you such advice.

Tax Deduction

Life insurance is a considered as a personal investment since it provides financial stability and security to one’s beneficiary or beneficiaries. Because of this, you cannot deduct your premiums from your federal income tax.

Cash Value – Tax Deferred

The Tax Court was held – in a case involving a cash-basis taxpayer – that the taxpayer did not constructively receive the cash values where he could not reach them without surrendering the life insurance policy. The necessity of surrendering the life insurance policy constituted a substantial “limitation or restriction” on their receipt.

In simpler terms, permanent life insurance policies have a cash value component. Ultimately, this amount will exceed the premiums you pay. Meaning, you can defer income taxes as long as you don’t sell, surrender or withdrawal from the policy.

Premium Payments

Determining on whether your premiums are paid with pretax or after-tax dollars is an important factor when dealing with life insurance taxation.

Generally, if you purchase a policy on your own or through your employer, your premiums are paid with after-tax dollars. If you purchased your policy through a qualified retirement plan, your premiums are made with pre-tax dollars.

Nowadays, most insurance companies do not sell life insurance inside a qualified plan.

Policy Loans

Policy loans under life insurance policies are not treated as distributions, assuming the policy qualifies as life insurance under IRC Sec. 7702 and is not considered a modified endowment contract.

Upon lapse or surrender, the outstanding loan balance is automatically repaid from policy values held as collateral – death benefit is reduced by the amount of the policy loan.

However, this use of collateralized policy values to repay a loan during a lapse or surrender may cause the recognition of taxable income.

Cash Withdrawals

Living proceeds received under life insurance contracts – that satisfy the conditions of the

seven pay test” of IRC Sec. 7702A (B) (i.e., not modified endowment contracts) – are taxed according to the FIFO method of accounting.

They are taxed under the “cost recovery rule” no matter when the contract was entered into or when premiums were paid.

You are allowed to withdraw portions of the cash value – tax-free – if it is up to your basis (i.e., the amount of premiums paid into the policy). If any withdrawals exceed your basic, it will be taxed as ordinary income.

Remember that cash withdrawals ultimately reduce the death benefit, which your beneficiaries will receive

Note: This information is based on certain life insurance policy, tax, and legal assumptions, but it not meant as legal or tax advice and is, also, subject to change. Only your attorney, accountant, or other tax professional can give you such advice.

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Consumer Insurance Guide SM provides a wide selection of originally-authored articles and expert advice targeted to the self-directed insurance shopper. Our mission is to provide consumers with useful, money-saving information on all things having to do with making sound insurance purchase decisions.